27 November 1995 CICA Roundtable, 9530990 - REPORTING OF FINANCIAL INSTRUMENTS

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

	Does treatment of debt or equity for tax purposes depend 	on legal form or accounting treatment?

Position:

Generally, follow legal form.

Reasons:

see attached

TAX EXECUTIVE INSTITUTE
November 1995

Question - XXIII

NEW CICA HANDBOOK SECTION 3860 - FINANCIAL INSTRUMENTS

The CICA recently finalized Handbook Section 3860 on the disclosure and presentation of financial instruments, which will be effective for financial years commencing on or after January 1, 1996. The new section is the first phase of an ongoing CICA project to develop comprehensive accounting standards for the recognition and measurement of financial instruments.

In applying the recommendations of the new section, the issuer of a financial instrument will initially classify an instrument, or its component parts, as a liability or as equity in accordance with the substance, rather than the legal form, of the contractual arrangement. A financial liability is defined as any liability that is a contractual obligation to deliver cash or another financial asset to another party, or to exchange financial instruments with another party under conditions that are potentially unfavourable. An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. The Handbook specifies that the classification of instruments as debt or equity should be applied retroactively with restatement of prior period financial statements.

Under these new requirements, financial instruments that were previously presented as debt may be reclassified as equity and, conversely, instruments previously presented as equity may be reclassified as debt. For example, preferred shares that are mandatorily redeemable, or are redeemable at the option of the holder, must be classified as debt rather than equity. Furthermore, even though the preferred shares may not explicitly include redemption provisions, classification of the shares as debt is mandatory where the terms and conditions of issuance indirectly oblige the issuer to redeem the shares.

The Handbook recommends that dividends paid and any gain or loss related to the preferred shares reclassified as debt be reported in the income statement. Conversely, interest paid and any gain or loss relating to a debt obligation reclassified as equity would be reported as part of the equity of the issuer.

Would Revenue Canada confirm that classification for accounting purposes under the new Handbook recommendations, which may differ substantially from the legal form of an instrument, will not change the treatment of dividend and interest payments for tax purposes?

Department's Position

We have not had the opportunity to fully consider the new reporting requirements for financial instruments set forth in Handbook section 3860. However, the classification of a particular financial instrument as debt or equity for accounting purposes is generally not determinative of its treatment for income tax purposes since it is the legal form of the particular financial instrument, not its economic substance, that usually will determine whether it is treated as debt or equity for the purposes of the Income Tax Act (Act). While the Act does deem payments of interest or dividends on certain financial instruments to be treated differently from their legal form (ie. small business bonds, small business development bonds, income bonds and certain term preferred shares issued by non-residents) generally payments of interest or dividends usually derive their income tax consequences from the legal nature of the payment.

This does not mean that the payments are not reviewable under the general anti-avoidance rule.

Author: Michael Cooke
Date: November 27, 1995
File: 953099